Taming the tantrums
The headline could have come from a hundred places any time in the last hundred years. “Market has gone wild”, it read. The accompanying news report explains that the price of a crucial financial asset is in “free fall”. Traders and businessmen are calling on the government to step in.
The asset in question could be peripheral euro zone government debt today, global equity markets in early 2009. The wild market could have been soaring rather than falling: the stocks of 1929 and 1999, the house prices in Florida or London in the 2000s, or the supposedly safe government bonds today.
The actual headline comes from a Hong Kong newspaper in 1983, when investors in the then British colony began to fear the worst from a Chinese takeover. The UK’s Minister of State told the locals to “have confidence in yourselves”, but, as today’s Spanish and Italian politicians can ruefully confirm, such rhetoric is not enough to stop an investor stampede. A few weeks later, the Hong Kong authorities did indeed take the matter out of traders’ hands – they fixed the exchange rate between Hong Kong and U.S. dollars.
Under the leadership of Alan Greenspan, the U.S. Federal Reserve took the opposite approach. With a few dramatic exceptions, it trusted the ultimate wisdom of markets. That laissez faire faith was a mistake. If the Fed had intervened to limit house price increases a decade ago, the current economic malaise might well have been avoided.
Interventions are helpful because wild financial markets are one of the worst aspects of the modern economy. Financial asset prices can move fast for no good reason. When they rise too high, they provide misleading signals, which misdirect the flow of investment. When prices fall too far, the damage to the real economy of goods and services can be severe and long lasting. Damage to factories and roads is relatively easy to repair; it only took a few months for the global supply chain to recover from 2011’s severe Japanese earthquake. The damage from the financial crisis of 2008 still lingers.
The financial sector is more fragile than the real economy for two reasons. The first is an unavoidable difference between financial assets and other purchased goods. The perceived value of stocks, bonds and the like depends on the buyers’ dreams and hopes. Dreams often exaggerate reality, for better or worse, and hopes once dashed, are not easily restored. It is much harder to get carried away in the rest of the economy, which deals primarily in actual products in the here and now.
The second reason is an intellectual mistake: an unjustified respect for the wisdom, efficiency and utility of financial markets. Regulators, economists and much of the general public treat the market prices of shares, bonds and oil like the utterances of an infallible oracle, even when these prices are more like the random demands of an overtired two-year old.
If the financial toddler is not stopped, the tantrum can end in the economic equivalent of broken toys and hysterical tears. A calm parent is needed to calm financial frenzy. The authorities should restrain financial dreams and moderate financial hopes. In other words, they should be bold enough to just say no to markets.
For all the post-crisis talk of financial stability, central bankers and regulators remain shy about using their powers. The European Central Bank, for example, objects on principle to the obvious response to investors’ hysterical flight from some euro zone members’ government bonds: buy the unpopular instruments. The ECB’s hesitation could lead to the demise of the single currency. The right principle is that whenever financial asset prices are moving too fast in either direction, bank regulators and central bankers should feel free to intervene directly in markets, set new requirements for bank capital and loan collateral or print or destroy money.
Such an activist agenda infuriates enthusiasts of free markets, but they should recognise that freedom is often best protected by restraint. In the real economy, the freedom of airlines, food producers and the like is limited by detailed regulations on everything from product safety and labelling to labour practices and environmental impact. The constraints maintain competition that is helpful to society. More restraints on financial markets would make them more capable of doing their real job – allocating capital and setting prices in normal times.
Like parents, financial market overseers will not always get it right. The experts will sometimes exert too little discipline and sometimes too much. But just as toddlers are less trustworthy than fallible parents, overexcited traders deserve less respect than a group of intelligent people with a simple goal – to avoid financial excess.
Dramatic headlines may get most of the attention, but the economy would benefit from more dull ones, along the lines of “Tantrum averted”.